Passage of Financial Reform Will Make Us Safer, at a Reasonable Cost

After a long struggle, financial reform legislation is about to become law, now that the Senate has passed the Dodd-Frank bill [note: President Obama signed the bill on July 21]. The bill is a good one, better than we had a right to expect given the complexity of the issues, the importance of this sector of the economy, the power of the vested interests fighting change, and the partisan political obstacles to accomplishing anything major in Washington.

It does not do everything one would ideally want, it does not always make the optimal choices about solving the problems it does tackle, and it has some outright mistakes in it. Realistically, though, how could legislation this sweeping not have these flaws? In my view, the bill, plus upcoming regulatory actions, will get us two-thirds the way to where we should be, which is a major improvement on our current situation.

The bill will make us safer although it will not eliminate future financial crises. Periodic crises are an inherent feature of market capitalism, or indeed any economic system run by humans. What it will do is to make these crises less frequent and considerably less damaging to the economy. This safety comes at a cost, though; economic growth is most years is likely to be a bit slower because banking will be modestly more expensive—loans will be a little costlier and a little harder to get. This is a trade-off worth making, because the real benefit will be from avoiding the severe economic damage that comes in crisis years. The recent recession triggered by the financial crisis has destroyed millions of jobs, instigated a process that will nearly double our national debt, and reduced the size of the world economy by trillions of dollars compared to where we would otherwise be in a few years. Virtually nobody wins, including the financial sector, from a regulatory approach that allows such crises to be this vicious, even if they are infrequent.

Dodd-Frank closely follows the original administration proposals in broad outline. I believe that approach is the right one—it seeks a balance between increasing systemic safety and allowing markets to operate efficiently. Striving for that balance has left it open to strong criticism from left and right. Progressives would like to have seen more radical changes, such as breaking up the large banks, outlawing many types of transactions that are seen as purely speculative, and limiting bonuses fairly severely. Conservatives would have preferred much less change, fearing that the bill represents a government takeover of the industry that will drown it in regulation and sharply increase costs.

I view the administration’s approach as analogous to FDR’s actions to fight the Great Depression. He could have concluded from the massive economic problems that capitalism had failed and had to be rejected in favor of socialism, fascism, or some other “ism.” Or, in theory, he could have decided that it was too dangerous to tinker and that the system would eventually correct itself. Instead, he chose to keep the core elements that make capitalism work effectively, but to create regulations to avoid the worst problems and a safety net of government aid to protect those that suffered. Similarly, the administration concluded that the core elements of our financial system needed to be preserved while adding considerable regulation to deal with the worst problems and mandating substantial additional safety buffers, such as higher capital and collateral requirements. I believe that approach is the right one, despite the calls for more or less action coming from both sides.